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COPYRIGHT NOTICE: Edited by Richard H. Thaler: Advances in Behavioral Finance, Volume II - page 2 / 23





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Chapter 1

A SURVEY OF BEHAVIORAL FINANCE Nicholas Barberis and Richard Thaler

1. Introduction

The traditional finance paradigm, which underlies many of the other arti- cles in this handbook, seeks to understand financial markets using models in which agents are “rational.” Rationality means two things. First, when they receive new information, agents update their beliefs correctly, in the manner described by Bayes’s law. Second, given their beliefs, agents make choices that are normatively acceptable, in the sense that they are consis- tent with Savage’s notion of Subjective Expected Utility (SEU).

This traditional framework is appealingly simple, and it would be very satisfying if its predictions were confirmed in the data. Unfortunately, after years of effort, it has become clear that basic facts about the aggregate stock market, the cross-section of average returns and individual trading behavior are not easily understood in this framework.

Behavioral finance is a new approach to financial markets that has emerged, at least in part, in response to the difficulties faced by the tradi- tional paradigm. In broad terms, it argues that some financial phenomena can be better understood using models in which some agents are not fully rational. More specifically, it analyzes what happens when we relax one, or both, of the two tenets that underlie individual rationality. In some behav- ioral finance models, agents fail to update their beliefs correctly. In other models, agents apply Bayes’s law properly but make choices that are nor- matively questionable, in that they are incompatible with SEU.1

We are very grateful to Markus Brunnermeier, George Constantinides, Kent Daniel, Milt Har- ris, Ming Huang, Owen Lamont, Jay Ritter, Andrei Shleifer, Jeremy Stein and Tuomo Vuolteenaho for extensive comments.

It is important to note that most models of asset pricing use the Rational Expectations Equilibrium framework (REE), which assumes not only individual rationality but also con- sistent beliefs (Sargent 1993). Consistent beliefs means that agents’ beliefs are correct: the subjective distribution they use to forecast future realizations of unknown variables is in- deed the distribution that those realizations are drawn from. This requires not only that agents process new information correctly, but that they have enough information about the structure of the economy to be able to figure out the correct distribution for the variables of interest. 1

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